In mediocre payout situations, transaction proceeds are unlikely to give a substantial (if any) return to common stockholders, yet may be sufficient to at least return the initial investment, and perhaps a liquidation premium, to preferred stockholders. In such a scenario, the practical implementation of fiduciary duties for privately held boards has historically been somewhat murky.
Prior to 2013, many issues generally surrounded liquidation payouts to preferred investors when allocated among various series of preferred investments, whether structured as bridge notes that attached large additional preferences, or as a pay-to-play, which immediately diluted non-participating legacy stockholders at the time of a bridge financing.
The 2013 In Re: Trados, Incorporated Shareholders Litigation case in Delaware renewed attention on this area by applying the rigorous “entire fairness” legal review standard to a board’s actions when it was unclear that a board was zealously evaluating the impact of decisions on all stockholders, as opposed to just preferred stockholders. The entire fairness standard, first set forth in the decision in Weinberger v. UOP, Inc. in 1983, requires the board (and not the plaintiffs) to prove that both a fair process and fair price were obtained for the stockholders. Although the Trados board happened to prevail on its particular facts, this rigorous standard highlights Delaware’s ongoing concerns in this context.
Despite the often-mandated acquisition of directors and officers liability insurance “tail policies,” public company acquirers are advised to more closely scrutinize the circumstances of a liquidation where the proceeds are unlikely to materially benefit all stockholders either by class (common/preferred) or series within a class (such as Series A or Series B). Retrospective reallocation of pieces of the pie among stockholders may cause unwanted negative publicity, management distraction and turbulence with continuing employees who are vital to making an acquisition work within the buyer’s organization.
The quandary of a “so-so” exit
Not all startups exit with values akin to Facebook’s acquisitions of WhatsApp, Oculus VR or Instagram. For startups that do not hit it out of the park – which is the majority of them – the fact pattern resembles in the following:
Prior to 2013, the answer was relatively simple. A target’s board of directors is usually ‘packed’ with members from investing venture capital funds and current members of management but rarely includes former CEO founder types or other former employees who vested on common stock prior to their departure). This mashup of VC investors and current management, with an occasional outsider thrown in, seeks the best price. In a lukewarm valuation scenario, that price may not be enough to pay off the liquidation preference overhanging the target – leaving little or perhaps nothing for holders of common stock. Yet employees hold common stock, meaning there is little incentive for those employees to hang around.
Alternative #1: The target’s board adopts a carveout or management incentive plan, reallocating some proceeds from a stockholder payout to employees to encourage them to remain. However, that results in lower proceeds for common stock holders, or even earlier preferred stock investors who must wait in line for the last-in investors to be paid their liquidation preference.
Alternative #2: The buyer embraces identified target employees and a promises a post-closing retention plan – but it then turns around and reduces the proposed purchase price to account for the post-closing retention value.
Historical focus on preferred stock payouts: The complicated issues in this situation historically revolved around circumstances where either the deal value was insufficient to pay the liquidation preferences for various early-stage venture investors even though a later stage preferred round may be paid in full – and even more thorny situations such as the infamous pay-to-play, where equity holders who do not participate in the bridge lifeline extension of cash either do not receive the 2X-5X preference in paying off such notes (thereby cramming them down further on the chain in a liquidation payoff when/if it occurs), or, in a true pay-to-play, the non-participating investors are massively diluted (crammed down) at the time of the new fundraising.
Management carveouts were routine: However, until 2013, “management carveouts” were an ordinary course feature of deals where venture capital investors wanted to retain employees in order to preserve some sort of saleable enterprise. The major downside of a carveout plan is that the proceeds to an employee would be tax characterized as ordinary income rather than capital gains on holding stock, since the extra money was not linked to their stockholdings but rather than their continued employment services to the company.
Trados reaffirms board duties to all stockholders: The 2013 In Re: Trados, Incorporated Shareholders Litigation emphasized that a board owes fiduciary duties to all stockholders – and using a management carveout to strip money from stockholders lower in the liquidation food chain than the venture capital funds affiliated with board members in order to give that money to people who would otherwise have no right to such money upon a liquidation invites great scrutiny from Delaware courts. While there are cogent business reasons to institute a management carveout, and Delaware is open to reasonable arguments, as shown in the eventual substantive outcome of Trados, there also is the outward danger of self-interest in venture capital funds and current management manipulating a carveout to deny the financial benefit of a liquidation to ousted founders, former employees or disillusioned prior investors. It is that very potential for abuse, even if most in Silicon Valley would posit it is far from the norm, that creates judicial review.
After-effects of Trados: Some commentators have suggested writing into a company’s certificate of incorporation that individual board members owe a duty more to their nominating entities (i.e. venture capital firms) than to all stockholders. There has been informal Delaware guidance that this would at least put other stockholders on notice. Left unsaid, however, is that savvy founders will likely become nervous and perhaps lurch even further towards dual class control plans (à la Facebook, Broadcom and others) to retain governance control.
The awkward position of a buyer: Leaving aside prospective machinations in startups, the implications of Trados leave an incoming buyer in an awkward position. By definition, a target will be loath to share details of the sale process with a buyer, lest it reveal how much leverage a buyer has in the process. However, in a management carveout situation – in which the sale may become subject to having to prove a “fair process/fair price” – a buyer needs to ask process questions of a target to at least get to the “fair process” prong. Although it is highly unlikely that Delaware would seek to unwind a deal post-closing, it is entirely foreseeable that a post-closing judicial quarrel between classes of stockholders would likely disaffect target employees who continue with the buyer. Those are the very people whom the buyer would like to completely focus on executing in the present, rather than struggling with post-facto examinations of value. Although the buyer’s liability is somewhat limited, in that Delaware courts scowl upon any indemnification of directors who are found to have breached their duty of loyalty, the uncertainty and publicity of ongoing litigation should be sufficient downsides to persuade a buyer to spend time on this subject with a target.
Nine practical remedies for acquirers
Among the practical remedies for acquirers in the prototypical “mediocre” deal, where payouts to common stockholders appear meager and/or a management carveout plan exists, are these:
Focus any post-closing employee incentives as forward looking: Understand that rich post-closing equity or bonus plan incentives for continuing target employees may create the appearance of colluding with a target’s board to deny common stockholders merger consideration. Structure such incentives to be forward looking, either through time-based vesting or use of performance goals that are measured from post-closing and thus do not appear to reward pre-closing service (at the expense of money that would otherwise go to common stockholders).
Article prepared by and republished courtesy of our colleague Ed Batts; originally published here: http://www.dlapiper.com/en/us/insights/publications/2014/04/muddy-employee-incentive-issues/.
The Venture Alley
The Venture Alley is a blog about business and legal issues important to entrepreneurs, startups, venture capitalists and angel investors. The Venture Alley is edited by Asher Bearman, Trent Dykes, Andrew Ledbetter, and Megan Muir, corporate and securities lawyers at DLA Piper.
Contributing authors to The Venture Alley include corporate and securities lawyers from the Seattle office of DLA Piper, which Chambers USA describes as "[a] team that exceeds all expectations" (Chambers USA: America's Leading Lawyers for Business 2010), as well as attorneys from other DLA Piper offices and practice areas. In addition to representing entrepreneurs, startups, venture capitalists and angel investors, DLA Piper's lawyers also assist some of the nation's top companies with their SEC reporting, public offerings, M&A, cross-border transactions and general commercial and securities litigation.
Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from DLA Piper. This work reflects the law at the time of writing, April 2014.
|Muddy Employee Incentive Issues In A Disappointing Exit: 9 Practical Tips For Public Company Acquirers|
|Second Circuit Declares WARN Act Liability of Operating Subsidiary May Be Imposed Upon Parent Holding Company|
|How Venture Capitalists Talk: You Can Make It ... Will Someone Buy It?|
|A Simple Act of Congress to Make Things Better for Startups|
|Big Boys Take Big Risks: Big Boy Letter Bars Investor State Law Fraud Claims|
|04/23/2014||Muddy Employee Incentive Issues In A Disappointing Exit: 9 Practical Tips For Public Company Acquirers||Trent Dykes - DLA Piper LLP - The Venture Alley|
|04/22/2014||Second Circuit Declares WARN Act Liability of Operating Subsidiary May Be Imposed Upon Parent Holding Company||Mitchel "Mitch" H. Perkiel and Carolyn Peterson Richter of Troutman Sanders LLP|
|04/17/2014||How Venture Capitalists Talk: You Can Make It ... Will Someone Buy It?||Joseph W. Bartlett, Special Counsel, McCarter & English LLP|
|04/16/2014||A Simple Act of Congress to Make Things Better for Startups||William Carleton, Contributing Editor, VC Experts|
|04/15/2014||Big Boys Take Big Risks: Big Boy Letter Bars Investor State Law Fraud Claims||Owen Pell and Francis Fitzherbert-Brockholes of White & Case LLP|
|04/10/2014||What Entrepreneurs Need To Know About Stock Options||Joseph W. Bartlett, Special Counsel, McCarter & English, LLP|
|04/09/2014||Non-Accredited Crowdfunding: A License To Pillage The Vulnerable, Or Democracy In Action?||William Carleton, Contributing Editor, VC Experts|
|04/08/2014||Siga Technologies And The Boilerplate Fallacy||Joseph W. Bartlett, Special Counsel, McCarter & English LLP|
|04/03/2014||7 Tips for Start-Ups||Joseph W. Bartlett, Special Counsel, McCarter & English, LLP|
|04/02/2014||SEC Official To Angel Community: Go Ahead, Develop Your Own Verification Methods!||William Carleton, Contributing Editor, VC Experts|
|04/01/2014||Strategic Considerations for Start-Up Private Equity Fund Managers||Bradley M. Van Buren and Frank M. White Jr. of Holland & Knight LLP|
|03/27/2014||2 Common Down-Round Characteristics, Feat. Jiwire||VC Experts Intelligence Team|
|03/26/2014||Delaware Chancery Court Decisions Highlight That A "Crucial Difference" In Analyzing Director Liability For "Bad Faith" In the Context of an M&A Sales Process Is the Seriousness of the Bidder||David A. Niemeyer of Sheppard Mullin Richter & Hampton LLP|
|03/25/2014||SEC No-Action Letter re M&A Brokers||Andrew M. Ross of Cozen O'Connor|
|03/20/2014||Three Common Stock Transactions That May Affect Your IRC §409A Valuation||Jim Timmins, Managing Director of Teknos Associates|
|03/19/2014||Further Thoughts About The Public Disclosure Requirements In The Washington State Crowdfunding Bill||William Carleton, Contributing Editor, VC Experts|
|03/18/2014||Top Ten Tips for Purchasing and Negotiating Representations and Warranty Insurance||Micah E. Skidmore of Haynes and Boone, LLP|
|03/13/2014||White Paper: Navigating Change in the Private Capital Markets||ACE Portal|
|03/12/2014||In A Merger, When Are Preferred Stockholders Not Entitled To A Liquidation Preference Payment?||Peter J. Walsh, Jr., T. Brad Davey, Thomas A. Mullen, and David B. DiDonato of Potter Anderson & Corroon LLP|
|03/11/2014||Looking Under The Hood At The Washington State Crowdfunding Bill||William Carleton, Contributing Editor, VC Experts|